Saturday, February 19, 2011

I came accross a blog post in the Huffington Post that I would like to share with my readers. The author, Nathaniel Cahners Hindman, wrote an article titled "8 Ways to Bootstrap a Business Without Going to a Bank". The link to the article is here.

So, for the start-ups out there: are you equally exploring all these options? I meet many start-up owners looking for angels or VCs. But how many of you know enough about the other six ways to finance your business?

Looking for less traditional sources of capital, just like thinking outside of the box, may be just what you need to enable your business meet yet another milestone and continue to grow.

In my previous blog post, I described the federal and state laws that apply to friends and family rounds of financing. To an entrepreneur trying to raise only $100,000, this will sound complicated and even overwhelming, as well as expensive. Preparing extensive disclosure statements and making the necessary filings require hiring an attorney, and legal fees may make the whole offering not worth pursuing.

The market need for conducing family and friends rounds of investing in an efficient and cost-effective manner has generated a response in terms of crowd funding. One of the companies in the crowd funding space is a newcomer called ProFounder. This is the way it works: A start-up founder who wants to get funds from family and friends creates an account with ProFounder. He describes the company, its financials, the investment terms, and risks associated with the investment. Investment terms are simple: founder offer a share of their revenue in exchange for the investment (ProFounder currently offers only revenue sharing, but nothing bars founders from offering other terms through other crowd funding sites). A term sheet is then created and emailed to the friends and family of the founder (i.e., people with whom the founder has personal pre-existing relationship). Those interested reply and the offering is consummated. Average investor invests only about $1,500, and an average round is between $35,000 and $60,000. ProFounder also educates the founders on how to comply with each state’s securities laws and provides guidelines for the filing of the necessary forms and paying the necessary fees. It is the founders’ responsibility to do so in a timely manner.

Assuming compliance with all applicable state and federal securities laws, the idea of crowd funding is appealing. It is very inexpensive and easy to do. It also eliminates the necessity of hiring an attorney, potentially saving the start-ups thousands of dollars. In fact, crowd funding may be just the response we all need to the problem of securing investments from the general public instead of VCs or professional investors. It opens doors to millions of investors who can contribute small amounts to social ventures and start-ups that would otherwise go unnoticed by the professionals.

Note that crowd funding is not for everybody and in certain situations business owners would be well advised to hire an attorney.

Typically, the first people that start-up founders turn to for financing are their friends and family. Of course, most friends and family members are not going to worry about valuations, projections, business strategies. They invest because of their trust and strong personal ties to the founders.

Actually, friends and family rounds of investing are securities offerings and, like all other offerings, have to be either registered with the SEC or fall under one of the exemptions from registration. I want to briefly touch upon two such exemptions, Rules 504 and 506 of Regulation D. Also, each of these offerings has to comply with the applicable state securities laws (blue-sky laws) in each state where the friends and family members reside.

Rule 506 of Regulation D allows a private placement of securities to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors. See description of Rule 506 here . Accredited investors’ definition includes individuals who have (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase (not including the value of the primary residence); or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year. If the founders’ friends and family members who are willing to invest are all accredited investors, then the compliance is quite simple: there is no need for extensive disclosure, although some disclosure is still recommended. The offering then must be conducted without general solicitation or advertising; issued securities are restricted, and the company must file a Form D with the SEC within 15 days of the first sale of securities.

If, however, not all of the investors are accredited, founders will need to provide a lot more disclosure to the investors, including a full-blown private placement memorandum, risk factors and financial statements. Also, note that all non-accredited investors in a Rule 506 offering must be sophisticated, which means that the company must reasonably believe that non-accredited investors (either alone or together with their investment representatives) have sufficient financial and business knowledge to allow them to evaluate the risks and merits of an investment.

Rule 504 of Regulation D applies to offerings of less than $1 million and allows such offerings to be made to non-accredited and non-sophisticated investors so long as the company is not subject to any reporting requirements of the United States Securities Act of 1933, such as most public companies, and is not formed solely for investment purposes. Also, the exemption generally does not allow companies to solicit or advertise their securities to the public, and purchasers receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption.

Rule 504 does allow companies to sell securities that are not restricted and to engage in solicitation and advertising if one of the following circumstances is met (using the SEC description of the Rule at http://www.sec.gov/answers/rule504.htm):

“(1) The company registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors;

(2) A company registers and sells the offering in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the offering to all purchasers (including those in the state that has no such requirements); or

(3) The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to accredited investors."

Compliance with Blue Sky Laws

Regulation of Rule 506 offerings is preempted by federal laws. States can generally only require a notice and a filing fee but cannot impose their own regulations. Most states ask for a copy of Form D (which the companies have to file with the SEC within 15 days of the offering) and a fee (typically, about $300). Of course, regulation varies by state, and about five states require pre-filing. For example, New York requires the pre-filing of Form 99 (Notification Form Under NSMIA), a State Notice, a Further State Notice and Form U-2 if the company has been formed outside of New York. The filing fee in New York is $300 for offerings under $500,000.

In case of Rule 504 offerings, New York provides an exemption for offerings to 40 or less investors.
More information can be found at this link.

Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the investors (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

Please note that this blog is written for general informational purposes only and does not constitute legal advice or create any attorney-client privilege.

This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Wednesday, February 9, 2011

Currently in the United States, about 380 B Corporations are solving social and environmental problems across 52 industries. A Certified B Corporation is a new form of business that adds social and environmental criteria to the financial criteria in measuring the business’ success. These B Corps are there to make a difference, and it makes a lot of business sense. According to the B Lab’s data, 60 million of Americans (23% of US adult population) make purchasing decisions based upon social and environmental values, and $2.7 trillion out of $25.1 trillion of professionally managed investments are so called Socially Responsible Investments. As the values in the United States shift towards impact investing, B Corps are well positioned to attract capital and make an even bigger impact in the economy.

The B Corporation certification is a third-party certification, a product of B Lab, a non-profit that about 3.5 years ago identified a market need for a small business certification. It is not the only certification out there, and it may get confusing to determine which certification is most appropriate. Certified B Corporations are mostly small to medium-size businesses (about half of B Corps have less than 10 employees). None of them are public companies. Most of them are consumer products companies, but there are also organic restaurants, financial firms and even law firms. The managers complete an online impact assessment test that consists of 120-150 questions. If the threshold is met, they can proceed towards certification. It is not easy to meet the threshold. The minimum passing score is 80/200. An average score (based on 4,400 test takers) is 40-50/200. An average business that has not taken any steps towards being more socially and environmentally responsible will only get about 10/200. The assessment is divided into five categories: accountability (corporate governance, transparency), employees (compensations, benefits, work environment, ownership of the company), consumers, community engagement and environment.

To become a Certified B Corporation, a business also needs to make changes to its legal documents. The governing documents (charter, operating agreement) have to be amended to redefine the interests of the corporation to include the consideration of employees, consumers, the community and the environment. Essentially, the goal of the corporation becomes broader than just maximizing the shareholder value. B Lab’s website contains model language that should be inserted into the governing documents depending on the business’ state of incorporation and type of business entity.

Approximately 12 states have already introduced and two states (Maryland and Vermont) have adopted a new legal form of business entity, a Benefit Corporation. According to the definition, in addition to any other legitimate purpose, every benefit corporation must have a purpose of creating general public benefit, which is defined as a material positive impact on society and the environment, as measured by a third-party standard. New York Senate is currently considering a similar bill (S00079). On January 5, 2011, it was refiled and referred to the Judiciary Committee.

We live in exciting times. People around us become more conscious of the environment and the long-term effect of businesses on the quality of our lives. Impact investing is now so popular that it may soon be considered to be a new asset class. State legislation, instead of being restrictive, should be leading and encouraging business owners to be more socially and environmentally responsible. Legal entity forms, such as L3C (see my earlier post) and Benefit Corporation, should become the new norm in all states.

About the Author

Arina Shulga is the founder of Shulga Law Firm, P.C. Arina Shulga is a corporate and securities attorney with significant experience in startup law, securities offerings and SEC reporting obligations, cross-border transactions, corporate governance, private and public company representation, periodic reporting filings for public companies, business entity formation, licensing, contracts and employment-related agreements. She is experienced with advising small to mid-sized companies on formation, contract review and negotiation, private placement of securities, intellectual property matters and internal governance issues. Check out her LinkedIn profile.

You can contact Arina at (646) 481-8001, by emailing her at arina@shulgalaw.com or by visiting Shulga Law Firm's website.